Recession Risks have Risen

March 30th, 2015
in contributors

X-factor Report 29 March 2015

by Lance Roberts, StreetTalk Live

I began writing several months ago that the fall in oil prices and subsequently gasoline prices, was not the economic "nirvana" that mainstream economists had hoped.

Follow up:

To wit:

"Graphically, we can show this by analyzing real (inflation adjusted) gasoline prices compared to total Personal Consumption Expenditures (PCE). I am using "PCE" as it is the broadest measure of consumer spending and comprises almost 70% of the entire GDP calculation."


"The vertical orange line shows peaks in gasoline prices that should correspond(according to mainstream consensus) to a subsequent increase in retail sales.

The reason is that falling oil prices are a bigger drag on economic growth than the incremental 'savings' received by the consumer."

Of course, those same economists, unable to accept the reality demonstrated by the data, now suggest that:

"Oh...the consumer decided to SAVE all those savings from low gas prices instead of spending them."

No..that would be wrong also.

As Tyler Durden at Zero Hedge pointed out after Friday's 3rd estimate of Q4-GDP:

"Last quarter, when we showed what was 'The Reason For The 'Surge' In Q3 GDP', some were shocked to learn that in the quarter in which US GDP posted a 5% surge, it was none other than Obamacare - a mandatory tax according to the Supreme Court which has the benefit of flowing through the US income statement - which contributed the bulk of this upside."


"We are happy, and we use the term loosely, that history has just repeated itself, and now that the final number is available, what we wrote a month ago in "Here Is What Americans Spent Their "Gas Savings" On" has just been confirmed, and as the chart below shows, in the final revision of Q4 GDP, while virtually every other category of household spending was largely unchanged or revised lower, it was Healthcare,of which Obamacare was the biggest contributor on the margin, which saw an unprecedented surge in total spending, from $1.858 trillion to $1.871.9 trillion just between the second and final GDP revisions: a bump of $13.9 billion, without which Q3 GDP would have grown well below 2%!"


"It gets better because in the fourth quarter total spending on healthcare in chained dollarswas a whopping $35.3 billion.An all time record!"


"Moreover, the absolute shocker: of the $89.1 billion increase in Q4 GDP in chained dollars, health care was $35.3 billion of that or 40% of the total.

Yes, health care spending accounted for 40% of GDP growth in Q4!"

Q1 GDP Will Likely Be Close To 0%

With Q4 now finalized at just 2.2% growth for the quarter, economic growth for the full 2014 year rang in at a rather dismal 2.38% in total. With inflation near its lowest levels, economic growth less than exhilarating, the Fed is now suggesting it is time to start raising interest rates.

As I wrote this past week:

"Atlanta Federal Reserve Bank President Dennis Lockhart said on Thursday there was little risk of a misstep that would force the Fed to lower rates once it begins raising them.

The economy is in solid shape to weather the upcoming turn to tightening monetary policy Lockhart, said at an investment education conference in Detroit.

'Conditions are pretty solid,' said Lockhart, who regards an initial rate hike at the June, July or September Fed meetings as a high probability. 'I take the decision pretty seriously,' Lockhart said. 'Once we start, I want to be able to move deliberately towards higher rates.'"

This is a pretty common meme among the majority of economists as of late, and particularly surprising coming from the Atlanta Fed President considering:

  • The U.S. is currently more than 6-years into an economic recovery (long by historic standards), and;
  • The Atlanta Fed's GDPNow forecast is pegging a near 0% growth rate for the first quarter.

However, let's take a look at the decline in durable goods orders this past week. Paul McCulley, the former legendary economist and fund manager at PIMCO, viewed durable goods a bit differently than the mainstream analysis given. He preferred the year-over-year trend of the 3-month moving average of core CAPEX orders as an indicator of broader economic activity over the next few quarters. If you are currently "bullish" on the direction of the US economy, you may want to take a closer look at the chart below.


Secondly, core CAPEX has been negative on a monthly basis for 6-consecutive months. Since 1992, there have only been 5-instances where core CAPEX orders have been negative for 4-or more consecutive months. The first three instances were leading indicators of future recessions. In 2012, there were 6-consecutive months of decline as the economy got very close to a recession but was saved by Central Bank interventions and the warmest winter in 65-year. The latest core CAPEX decline capped a second 6-month period as it appears that Q1 GDP will ring in close to zero.


I am not suggesting that the economy is about to slip into an immediate recession. However, I am suggesting that underlying economic strength in the U.S. is likely much weaker than headline statistics indicates.

4 Early Warning Recession Signs

It has been quite surprising just how much profit was extracted from each dollar of revenue earned through cost-cutting, accounting gimmickry and share repurchases. Of course, the reality is that the majority of those "profits" have only existed on the accounting statement and not in the hands American is through higher wages and incomes.

However, as I have repeatedly stated in the past, all of these measures of "manufacturing" profitability are "finite" in nature and at some point the "rubber will eventually meet the road." The following four charts suggest that day has arrived.


To measure the aggregate corporate ROE, we take the profit of all national U.S. corporations and adjust that profit to reflect its non-financial share, and then divide the result by the net worth of those same corporations measured at replacement cost including foreign assets. The following chart shows the metric from 1949 through 2014.


Historically, when there has been a plunge in corporate ROE, a recession has been on the horizon. Furthermore, considering that ROE is falling from a rather artificially generated peak, the risks of a further reversion is quite likely.

Corporate Profits & Dividend

Looking just at corporate profits can be somewhat misleading. However, if we apply a Kalecki-Levy profit equation and divide it by Gross National Profit, a better picture emerges.

[Profit/GNP] = [Investment/GNP] + [Dividends/GNP] - [Household Savings/GNP] - [Gov't Saving/GNP] - [Foreign Saving/GNP]

This equation shows that if corporations "hoard" profits, rather than investing back into the economy via wages and investment, the economy will suffer. This is because the other sectors of the economy lose income.

Currently, both corporate profits and dividends as a function of GNP has begun rather sharp declines as economic growth deteriorates and corporations "hoard" profits instead of reinvesting. Ironically, it is their "hoarding" that is sucking the rest of the economy dry.


Household Savings

The blue line in the following chart shows the household savings rate as a percentage of GNP from 1949 to 2014. The red line shows the housing savings rate as a percentage of GNP adjusted to reflect the household share of retained corporate profits:


As you can see, the red line is significantly below its average for the period. Since the mid-1980s, it is fallen by more than 50%. The more accurate blue line, in contrast, is only slightly below its average for the period. It is on par with the level of the mid-1980s-a period considered to be economically "normal."

From 2009-2013, household savings rates were on the rise. However, over the last year, those savings rates have been drawn down sharply to order to maintain expenditures and avert a recession in the presence of persistently high-profit margins.

As Jesse Livermore explained:

"When you hear claims that record-high corporate profits are coming at the cost of record low household savings, remember that the wealth in question is ultimately fungible. When it shifts from household "saving", as defined in NIPA, to corporate profit, it's not disappearing from the household balance sheet-rather, it's going from one part of the household balance sheet (the bank account) to another part (the brokerage account)."

However, the magnitude of the decline suggests that families have shifted a large chunk of their savings to maintain current economic stability. However, such actions come at a cost and historically have been a leading indicator of much slower economic growth rates.

Government Savings

As shown in the chart below of Government Savings/GNP, the sharp rise in savings since the financial crisis has been consistent with the sluggish economic recovery already experienced. However, should this ratio began to fall, it has historically been very coincident with the onset of a recession.


While I am not suggesting that a recession is imminent, what I am warning of is that there is a host of signs as of late that indicate we are entering into much more troubled waters.

As I discussed Wednesday,

"...the price of the market currently remains in a positive trend but the underlying momentum and strength measures are showing signs of a negative divergence. This suggests that while market prices are trending higher, the risks of a correction are currently rising as the 'supports' weaken.

The negative divergence of the markets from economic strength and momentum are merely warning signs and do not currently suggest becoming grossly underweight equity exposure. However, warning signs exist for a reason, and much like Wyle E. Coyote chasing the Roadrunner, not paying attention to the signs has tended to have rather severe consequences."

Have a great weekend.

Disclaimer: All content in this newsletter, and on, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on in developing investment objectives or portfolios for its clients. Please read the full disclaimer.

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